Cost Plus Pricing
Cost-plus pricing is a pricing method in which selling price of a product is determined by adding a profit margin to the cost per unit of the product. Cost per unit includes actual direct materials, actual direct labor, actual variable manufacturing overheads and allocated fixed manufacturing overheads.
Cost-plus pricing is appropriate where the units are not uniform and each order is different. In such cases, price equals the cost estimate plus a profit (which may be a percentage of cost or sales price or a fixed amount). Estimating correct cost per unit is important because incorrect estimation of cost affects the selling price and ultimately the competitiveness of the firm.
Advantages and disadvantages
Cost-plus pricing is easy to apply and in some situations, it is the only method to determine a price when the market price is not available, for example in case of government contracts.
However, despite its simplicity, it is not a preferred pricing method because it does not encourage efficiency. As compared to target costing, where price is fixed and companies have to keep costs low in order to squeeze in a profit, there is no such pressure in cost-plus pricing. Since all costs are reimbursed together with a profit, companies may not be motivated enough to keep costs at their optimum.
Formulas
The profit margin may be based on cost per unit or the ultimate price per unit or it may be a fixed amount per unit. Where the profit margin is based on cost, the price is calculated as follows:
Price = cost per unit × (1 + profit margin)
Where the profit margin is based on selling price, the price is calculated using the following formula:
Price = cost per unit / (1 – profit margin)
Where the profit is a fixed amount per unit:
Price = cost per unit + profit per units
Example
You work as a cost accountant at GP Engineers & Contractors (GP), which recently won a 10-year government contract for the provision of electricity to the country’s largest airport during power outages. For the purpose, GP is required to set up a small diesel-run power plant and operate and maintain it over the contract term. According to the contract, GP shall be reimbursed every month for the cost incurred per unit (kilowatt hour) of electricity consumed from GP system plus a 20% profit on cost.
During the first month, GP provided 98,000 units from its power plant to the airport. The plant consumed 30,000 liters of diesel during the month, which cost $1 per liter. Employees dedicated to the power plant earn $30,000 per month. Head office expenses allocated to the power plant on account of management fee for the monthly amount to $20,000. The plant is depreciated at the rate of $15,000 per month over the 10-year contract period.
You are, required to calculate the amount at which you will invoice the government for the first month?
Solution
Total cost for the first month
= diesel cost + labor cost + overheads cost (including depreciation)
= $30,000 (diesel cost @1 per liter for 30,000 liters) + $30,000 (direct labor) + $20,000 (management fee) + $15,000 (depreciation)
= $95,000
Invoice amount for first month
= $95,000 x (1 + 20%)
= $114,000
